Darkest Before Dawn

John Middleton, Portfolio Manager for the Mint Australasian Equity Fund 

Darkest before the dawn

Life feels pretty tough at the moment. The early positive sentiment from rate cuts late last year is now gone. Economic conditions remain under pressure. The housing market is flat, immigration is falling, and we are exporting kiwis to Australia again. Government continues to shrink and remain austere, and businesses are making hard decisions. New Zealand has been lucky enough not to feel like this since the GFC, but this is what the trough of a cycle feels like. 

Not really helping ourselves 

Typical kiwis, we have made life harder for ourselves than it needed to be. It is highly unusual for a Government to look to cut jobs while on the cusp of entering recession.  Equally Government does not normally turn off infrastructure spending and immigration when the economy starts to turn down.  In addition, we have also tightened up the lending requirements for banks and told them to increase the level of capital they hold, at a time when interest rates have been held high to combat inflation.

To be clear this is not intended as a dose of Government or Central Bank bashing. Indeed, we believe all these actions taken are sensible when looked at in isolation. But we maintain that enacting them together at broadly the same time as interest rates have remained high has caused the economic downturn to bite harder than it needed to. 

Always darkest before the dawn

The good news is, things are always darkest before the dawn, and we see rays of light coming from multiple different horizons. We believe that progress has been made both in the financial fabric of New Zealand, and in the stock market leaving both well positioned, notwithstanding the current economic uncertainty. Furthermore, we expect a number of fiscal headwinds to turn into tailwinds as the year progresses.

Interest rate cuts starting to help mortgage holders

Domestic inflation is back into its 1-3% target range which has allowed the RBNZ to start cutting rates. Tariffs have raised this risk that inflation could return, but the March and June prints of 2.5% and 2.7% respectively have enabled the RBNZ to take a more dovish stance and we would expect the cutting cycle to continue. 

Since 27 November 2024 the RBNZ has cut the Official Cash Rate (OCR) from 4.75% to 3%, with 15 out of 18 economists (according to a Reuters poll) and ourselves, expecting a further 25 basis point cut on 8th October. We would also note that the rhetoric from the US Federal Reserve has changed in recent months, which we believe should give the RBNZ greater flexibility to cut rates more aggressively going forward, if required. 

The thing to remember about rate cuts is that they typically take 12-24 months to stimulate the economy. Most New Zealand mortgages are fixed on 1-2 year rates (Australia and other markets mortgages tend to be more exposed to floating mortgage rates) and generally the term of the mortgage needs to come up to allow the holder to refix at a lower rates. So, while the OCR has been cut by 150 basis points since November 2024 the RBNZ’s B6 Yield on residential mortgages has fallen from 6.35% to 5.66% as at the end of June i.e. a fall of just 69 basis points. We would expect the yield on residential mortgages to continue to fall as the year progresses and support consumer spending. At the time of writing, advertised 1 and 2 year fixed mortgage rates are c. 4.75%

Fortress balance sheets, now to promote lending?

I would start by writing strong, well capitalised banks with less exposure to volatile earnings are a good thing. The GFC highlighted that an 8% capital ratio for banks was inadequate to protect the banking system from black swan events, particularly those banks exposed to riskier lending practices. We see higher capital ratios and a refocusing of banks on deposit taking and mortgage lending as a good strategy. 

The aim to increase capital ratios to 18% is laudable (NZ’s largest banks are currently required to hold 13.5% of loan capital) but this cannot be done for free, and we believe we are currently experiencing the unintended consequences of both these targets and stricter lending legislation. A de-risking of lending by the major banks has weighed on their willingness to lend and removed the oil from the banking sector system, at the time it is arguably most needed. 

We see the lack of non-performing loans over the current cycle as conspicuous. Clearly lower bad debts implies improving lending systems within the banking industry, but we fear that this also means that banks have stopped lending to “risky” areas of society with wider ramifications. 

We see recent comments that the RBNZ may look to ease lending capital requirements as a potential catalyst for the economy. It is not without risk, but we believe a combination of current capital held by our banks and the changes made to core business operations have already materially de-risked the banking sector.

Government, rebased, reset and refocused

The role of Government changed markedly over Covid with Government spending (and debt) rising rapidly over this period, arguably even more so in New Zealand than elsewhere. We see National’s move to make Government more efficient as needed and indeed later to manifest than for our international peers. But we fear the timing of our cuts have had a significant impact on the domestic economy.

Wellington Government cuts appear to be coming to an end and while we have yet to see Government spending as a percentage of GDP fall (partly due to declining GDP), we expect this to manifest over the months ahead. More importantly, with this Government rebase and reset behind us, we would expect refocused Government spending to increase over the months ahead. The Fast Track Approvals Act passed in December 2024 should take 12-18 months to move projects to main gate, so we expect to see new projects to start to get underway from early 2026.

Government spending rebasing at a new level is progress to the current status quo. We also see signs of targeted investment by Government that should increase going forward. The decision to allow those investing in new property development the ability to use depreciation to partially offset their tax while small could be a sign of things to come. The great hope is Government driven measures to improve kiwi productivity!!

Headwinds turning to tailwinds for equity markets as well

While we see headwinds turning to tailwinds for the wider economy, we also maintain that a number of the factors that have driven investors away from the New Zealand market have changed and might cause them to return. 

Dividends now higher than TDs again 

High interest rates have weighed on equity markets in terms of valuation, but in New Zealand they have also undermined one the markets main draw cards - the dividend yield. From 2022 onwards high interest rates meant that you could get a higher term deposit rate with the bank than from a NZX50 dividend yield, essentially removing the need for retail investors to hold equities to support their income. We believe this drove an exodus of capital from the New Zealand stock market.

As of the middle of 2025 this situation reversed with the market yield once again moving ahead of the rate offered by a term deposit. Before allowing for the tax benefit of owning funds. While the headline cash yield is 3.5%, this rises to >4.5% at the median level when low payers such as Fisher and Paykel Healthcare and Auckland Airport are equal weighted. The property sector has already seen some benefit from its attractive defensive yield, but there are numerous sectors (telcos, utilities, property) that offer both attractive and defensive yields in our view.

For the connoisseur, we would also note that the 3.5% dividend yield offered by the market, ceteris paribus, is set to rise from current levels. This is because a number of market constituents that historically paid a dividend (Ryman, Fletcher Building etc) currently don’t and the likes of A2 Milk are set to pay a dividend for the first time.

Balance sheets being repaired and expectations reigned in

It has taken time for corporates to recognise that they do not have enough capital to weather what is a severe market downturn or to fulfil their capital commitments. But we see most of these capital raises as now behind us and the fact that these were easily digested by the market as a sign of its improving health. 

Over the last 18 months we have seen major names like Auckland Airport, Ryman, Fletcher Building and Vulcan Steel (to name a few) raise equity. We have also seen the likes of Fletcher Building, Mainfreight and EBOS and our Utilities (due to less rain than expected) rebase their earnings expectations. While some earnings risk from business missteps and heightened international volatility remain, we believe most corporates have repaired balance sheets and have now rebased their earnings expectations to more realistic levels, so we see limited downside risk to both market earnings and dividends.

And the growth outlook looks attractive

A quirk of the New Zealand market also leaves earnings set for double digit growth going forward. This is in part due to the high growth of our largest index constituent Fisher and Paykel Healthcare and our power generation companies recovering from a dry 2025. Growth from these and the likes of Auckland Airport, Vector, A2 Milk and EBOS should support c10% EPS growth in 2026 and c8% in 2027. We see this growth as highly defensive in nature.

The best outlook for a decade

So, with an attractive yield, solid earnings and robust balance sheet, a stable political environment and scope for economic and fiscal tailwinds, we see the outlook for the New Zealand market as rosier than it has been for some time.